Lecture 3.2
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  • 1. CREDIT ANALYSIS FOR BANK LENDING
  • 2. I. Characteristics of Loan Outstanding by Banks Amount Percentage Smallest Largest ($billion) of Total Loans Banks Banks __________________________________________________________________________ Total Real Estate Loans $1,140 40.5% 55.8% 35.6% Loans to Financial Institutions 114.2 4.1 0.1 5.0 Loan to finance agricultural 41.3 1.5 10.9 0.6 Production and other loans to Farmers Commercial and industrial loans 709.9 25.2 16.3 27.4 Loans to individuals 560.9 19.9 15.4 20.7 Miscellaneous loans 171.7 6.1 1.0 7.4 Lease finance receivables 78.4 2.8 0.4 3.4 Total Loans 42,816.3 100% 100% 100% __________________________________________________________________________
  • 3. I. Characteristics of Loan Outstanding by Banks  Net Yields on Loans Earned by U.S. Banks Gross Yields Deductions for Net Yield Types of Loans on each loan Expenses Losses on loan ______________________________________________________________________________________ Real Estate Loans: Smallest banks 9.37% 1.46% 0.02% 7.88% Medium-sized banks 9.27 1.30 0.08 7.89 Largest banks 8.94 1..09 0.19 7.66 Installment Loans: Smallest banks 10.32 4.43 0.23 5.66 Medium-sized banks 10.37 4.11 0.44 5.82 Largest banks 9.75 3.56 0.74 5.45 Credit Card Loans: Smallest banks 17.51 22.55 0.71 –5.74 Medium-sized banks 24.33 19.13 2.39 2.82 Largest banks 24.52 20.53 1.88 2.12 Commercial and other loans Smallest banks 10.04 2.42 0.44 7.17 Medium-sized banks 9.98 2.69 0.34 6.96 Largest banks 9.35 2.43 0.33 6.60 ______________________________________________________________________________________
  • 4. I. Characteristics of Loan Outstanding by Banks  Nonperforming Loans as a Percentage of Total Loans  Quarter All Banks <$100m $100n-$1b $1b-$10b $10b+  _______________________________________________________________________  Commercial & Industrial Loans  December 1995 1.19% 1.32% 1.23% 0.98% 1.13%  December 1996 0.98 1.41 1.26 0.91 0.83  December 1997 0.86 1.26 1.19 0.84 0.71  December 1998 0.99 1.40 1.24 0.90 0.89  June 1999 1.11 1.58 1.24 1.03 1.02  Real Estate Loans  December 1995 1.39% 0.98 1.06 1.18 1.78  December 1996 1.23 0.94 0.92 1.28 1.40  December 1997 1.01 0.87 0.77 0.97 1.15  December 1998 0.91 0.87 0.71 0.84 1.02  June 1999 0.85 0.87 0.66 0.77 0.95  Consumer Loans  December 1995 1.22% 0.72 0.64 1.14 1.56  December 1996 1.36 0.84 0.79 1.42 1.50  December 1997 1.46 0.86 0.78 1.53 1.62  December 1998 1.52 0.92 0.81 1.54 1.69  June 1999 1.33 0.82 0.82 1.12 1.54  _________________________________________________________________________
  • 5. II. An Overview on Credit Analysis • Two goals: to make profitable loans with minimum risk. • The two goals should be balanced with the bank’s liquidity requirement, capital adequacy, and risk and returns target. • Strategic planning on business development is critical to lending decisions.
  • 6. II. An Overview on Credit Analysis Three functions in a credit process • Credit Analysis • Credit Execution and Administration • Credit Review
  • 7. II. An Overview on Credit Analysis 1. An Overview of Credit Analysis Three distinct areas for a credit analysis: • What risks are inherent in the operations of business? • What have managers done or failed to do in mitigating those risks? • How can a lender structure and control its own risks in supplying loans?
  • 8. II. An Overview on Credit Analysis The formal credit analysis procedure • Collecting information for the credit file • Spreading financial statements Ratio Analysis Credit Scoring Models • Projecting the borrower’s cash flows • Evaluating collateral • Summary & Recommendation
  • 9. II. An Overview on Credit Analysis 2. Credit Execution and Administration • Loan committee reviews proposal and recommendation • Accept/reject decision made, terms negotiated
  • 10. II. An Overview on Credit Analysis 2. Credit Execution and Administration  Establishing a Written Loan Policy  What should a bank’s written loan policy contain? – 1. A goal statement for the bank’s loan portfolio in terms of types, maturities, sizes, and quality of loans. – 2. Specification of the lending authority given to each loan officer and loan committee. – 3. Line of responsibility in making assignments and reporting information within the loan department. – 4. Operating procedures for soliciting, reviewing, evaluating, and making decisions on customer loan applications. – 5. The required document that is to accompany each loan
  • 11. II. An Overview on Credit Analysis 6. Lines of authority within the bank, detailing who is responsible for maintaining and reviewing the bank’s credit files. – 7. Guidelines for taking, evaluating, and perfecting loan collateral. – 8. A presentation of policies and procedures for setting loan interest rates and fees and the terms for repayment of loans. – 9. A statement of quality standards applicable to al loans. – 10. A statement of the preferred upper limit for total loans outstanding. – 11. A description of the bank’s principal trade area, from which most loans should come. – 12. A discussion of the preferred procedures for detecting, analyzing, and working out problem loan situations.
  • 12. II. An Overview on Credit Analysis 3. Credit Review  Credit review is to monitor the performance of outstanding loans and to handle problems loans  Scheduled information submission and routine check out on the adherence of loan covenants are required  Problem loans workout: to be or not to be
  • 13. III. Credit Analysis: What Makes a Good Loan? A. Loan Procedure 1. Overview of Management and options • Characteristics of the business and the related industry • Management quality • The nature of loan request • The data quality 2. Financial Ratio Analysis • Liquidity ratios • Leverage ratios • Profitability ratios
  • 14. II. An Overview on Credit Analysis 3. Statement of Cash Flows • Source and uses of funds • Source of loan payments • Timing of cash flows for loan payment 4. Financial Projection • Projecting financial needs of the borrowers • Projecting cash inflows from the options for loan payment • Determine when all the loan can be repaid
  • 15. II. An Overview on Credit Analysis B. Financial Analysis 1. The 5Cs in Determining Creditworthiness  Character (good citizen)  Capacity (cash flow)  Capital (wealth)  Collateral (security)  Conditions(economic, especially domestic vulnerability)
  • 16. II. An Overview on Credit Analysis Quantifying the 5Cs: • Character: willing to pay - past credit history - character reference - face-to-face interview • Capacity: measured by take-home pay, after-tax profits, or cash flows • Capital: a borrower’s net worth position • Collateral: quality of the assets • Economic Conditions: a borrowers’ vulnerability to an economic downturn or credit crunch
  • 17. II. An Overview on Credit Analysis C. Five C’s on Corporate Firms:  Production (measure of capacity and conditions): – On what production inputs does the applicant depend? – To what extent does this cause supply risk? – How do input price risks affect the applicant? – How do costs of production compare with those of the competition? – How does the quality of goods and services produced compare with those of the competition?
  • 18. II. An Overview on Credit Analysis C. Five C’s on Corporate Firms:  Management (measures of character and conditions): – Is management trustworthy? – Is management skilled at production? Marketing? Finance? Building an effective organization? – To what extent does the company depend on one or a few key players? – Is there a successful plan? – Are credible and sensible accounting, budgeting, and control systems in place?
  • 19. II. An Overview on Credit Analysis C. Five C’s on Corporate Firms:  Marketing (measures of conditions) – How are the changing needs of the applicant’s customers likely to affect the applicant? – How creditworthy are the applicant’s customers? – At what stage of their life cycles are the applicant’s products and services? – What is the applicant’s marketing policy? – Who are the applicant’s competitors? What policies are they pursuing? Why are they able to remain in business? – How is the applicant meeting changing market needs?
  • 20. II. An Overview on Credit Analysis C. Five C’s on Corporate Firms:  Capital (measures of capital and collateral): – How much equity is currently funding the firm’s assets? – How much access does the firm have to equity and debt markets? – Will the company back the loan with the firm’s assets?
  • 21. III. Modeling Credit Risk Analysis Credit Risk Factors: • Exogenous factors: state of the economy, natural disasters, etc • Endogenous factors: managerial discretion Those endogenous factors reflect management’s philosophy or attitude toward risk-taking
  • 22. Beta Analysis • To identify the bankruptcy risk of a corporation • Seven variables that are good discriminators between failed or non-failed business firms: - Return on Assets (EBIT/Total Assets) - Stability of Earnings (Standard error of ROAs) - Debt Service (EBIT/Interest Payments) - Cumulative Profitability (Retained Earnings/Total Assets) - Liquidity (Current Assets/Current Liability) - Capitalization (Market Value of Stock/Long- term Capital) - Size (Total Assets)
  • 23. Altman’s Multiple Discriminant Analysis Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 Where X1 = Working Capital/Total Assets X2 = Retained Earnings/Total Assets X3 = EBIT/Total Assets X4 = Market Value of Equity/Book Value of Total Asset X5 = Sales/Total Assets If Z < 2.675, assign to the bankrupt group If Z 2.675, assign to the non bankrupt group For 1.81 < Z < 2.99: Zone of Ignorance
  • 24. Another Scoring Model for Business Loans  To predict noncompliance with the customers’ original loan agreement.  Y = -2.0434 – 5.24X1 + .0053X2 – 6.6507X3 + 4.4009X4 - .0791 X5 - .1020X6 Where X1 = (Cash+marketable securities)/Total Assets X2 = Net Sales/(Cash + Marketable Securities) X3 = EBIT/Total Assets X4 = Total Debt/Total Assets X5 = Fixed Assets/Net Worth X6 = Working Capital/Net Sales
  • 25. Another Scoring Model for Business Loans The variable Y is viewed as an index of a borrower’s propensity for noncompliance and is used to calculate the probability of noncompliance: P = 1/(1+e-y) If P > .50, assign to the noncompliance group; If P < .50, assign to the compliance group.
  • 26. Consumer Loans  Duran used the following nine factors to classify good loans from bad loans:  Age: a score of 0.01 for each year of age over 20, with a maximum score of .30;  Sex: a score of .40 for a female, 0 oterwise;  Stability of Residence: a score of.042 for each year at present residence, with a maximum score of .42.
  • 27. Consumer Loans  Industry: a score of .21 for those employed in utility, government services, and banking and brokerage business.  Stability of Employment: a score of .59 for each year at employment, with a maximum score of .59  Three Asset Items: A score of .45 for a bank account, .35 for real estate, with a maximum for life insurance.
  • 28. Credit Scoring of a Real Estate Loan  Characteristic  Annual gross <$10 $10-$25 $25-%50 $50 $100 >$ 100.000  Income   Score 0 15 35 50 75   TDS >50% 35%-50% 15%-35% 5%-1 5% <5%   Score 0 10 20 35 50   Relations with FI None Checking Savings Both   Score 0 30 30 60   Major Credit Cards None 1 or more   Score 0 20   Age <25 25-60 >60   Score 5 30 25   Residence Rent Own with mortgage Own outright   Score 5 20 50   Length of <1 year 1-5 years >5 years  residence 
  • 29. Credit Scoring of a Real Estate Loan  The loan is automatically rejected if the applicant's ~ score is less than 120; the loan is  automatically approved if the total score is greater than 190. A score between 120 and 190 is reviewed by a loan committee for a final decision.   A loan customer listing the following information on the loan application receives the following points:   Characteristic Value Score  ___________________________________________________  Annual gross income $67,000 50  TDS 12% 35  Relations with FI None 0  Major credit cards 4 20  Age 37 30  Residence Own/mortgage 20  Length of residence 2 1/2 years 20  Job stability 2 1/2 years 20  Credit history Met all payments 50 • Total score = 245   The real estate loan is automatically approved.
  • 30. Causes of Problem Loans  1. Poor Management Quality – Lack of depth and diversity in management expertise – Inadequate planning and accounting systems – Outright fraud – General incompetence
  • 31. Causes of Problem Loans  2. Inadequate Initial Capitalization – Owners underestimate the costs of opening the doors for businesses and overestimate the speed at which they can turn a profit. – 3. High Financial and Operating Leverage – High financial leverage exposes the firm to large interest payments even when sales decline. – High operating leverage exposes the firm to substantial depreciation and maintenance expenses when sales decline.
  • 32. Causes of Problem Loans 4. High Sales Growth – A firm’s operating problems are accentuated when it grows to fast:  Inventory turnover slows  The collection of receivables slows  Operating overhead increases  More assets are needed  More financing is required. A bank must restrict the firm’s asset growth by forcing the firm to collect on sales and monitor inventory.
  • 33. Causes of Problem Loans  5. Strong Competition – A firm should regularly improve existing operations and introduce new products to remain competitive. – A firm could react to competition offensively or defensively. – Companies that do not adapt eventually decay.
  • 34. Causes of Problem Loans  6. Economic Downturn – Many firms cannot generate sufficient cash flows when the economy slows down, and they do not have assets to sell or expenses to cut. The resulting strain on cash flows forces firms to rely on increased bank borrowing until economic growth accelerates.
  • 35. 20 Common Reasons for Loan Losses  1. Collateral overvalued, improperly margined; failed to get appraisal.  2. Dispersal of funds before documentation finished.  3. Officer making “good old boy” loans, bypassing the loan committee. Personal friendship of loan officer with borrower.  4. Loan to a new business with an inexperienced owner-manager.  5. Renewing a loan for increasing
  • 36. 20 Common Reasons for Loan Losses  6. Repeatedly rewriting loan to cover delinquent interest due.  7. Not analyzing borrower’s cash flows and repayment capacity.  8. Failure of officer to review loan’s status frequently enough.  9. Funds not applied as represented; diverted to borrower’s personal use.  10. Funds used out of the bank’s market area; poor communications with borrower.
  • 37. 20 Common Reasons for Loan Losses  11. Repayment plan not clear or not stated on the face of the note.  12. Failure to receive or infrequently receipt of borrower’s financial statements.  13. Failure to realize on collateral because borrower raised nuisance legal defenses.  14. Bank failure to follow its own written policies and procedures.  15. Bank president too dominant inpushing through loan approval.
  • 38. 20 Common Reasons for Loan Losses  16. Ignoring overdraft situation as a tip-off to borrower’s major financial problems.  17. Failure to inspect borrower’s business premises.  18. Lending against fictitious book net worth of business, with no audit or verification of borrower’s financial statement.  19. Failure to get or ignoring negative credit bureau reports or other credit references.  20 Failure to call loan or to move against collateral quickly when deterioration